Identifying potential bond investments

Here’s a look at some items you need to evaluate before investing in a fund:

• Issuer stability: This is also known as credit quality, which assesses an issuer’s ability to pay back its debts, including the interest and principal it owes its bond holders, in full and on time. Although many corporations, the United States government, and a multitude of municipalities have never defaulted on a bond, you can expect that some issuers can and will be unable to repay.
  
• Maturity: A bond’s maturity refers to the specific future date when you can expect your principal to be repaid. Bond maturities can range from as short as one day all the up to 30 years. Make sure that the bond you select has a maturity date that works with your needs. T-Bills and zero coupon bonds pay interest at maturity. All other bonds pay interest every six months. Most investors buy bonds in order to have a steady flow of income (from interest).

The longer the maturity in a bond, the more risk associated with it — that is, the greater the fluctuation in bond value based upon changes in interest rates.

• Interest rate: Bonds pay interest that can be fixed-rate, floating, or payable at maturity. Most bond rates are fixed until maturity, and the amount is based on a percentage of the face or principal amount.
• Face value: This is the stated value of a bond. The bond is selling at a premium when the price is above its face value; pricing below its face value means that it’s selling at a discount.
• Price: The price you pay for a bond is based on an array of different factors, including current interest rates, supply and demand, and maturity.
• Current yield: This is the annual percentage rate of return earned on a bond. You can find a bond’s current yield by dividing the bond’s interest payment by its purchase price. For example, if you bought a bond at $900 and its interest rate is 8% (0.08), the current yield is 8.89% — 8% or 0.08 ÷ $900 = 8.89.
• Yield to maturity (YTM): This tells you the total return you can expect to receive if you hold a bond until it matures. Its calculation takes into account the bond’s face value, its current price, and the years left until the bond matures. The calculation is an elaborate one, but the broker you’re buying a bond from should be able to give you its YTM. The YTM also enables you to compare bonds with different maturities and yields. Don’t buy a bond on current yield alone. Ask the bank or brokerage firm from whom you’re buying the bond to provide a YTM figure so that you can have a clear idea about the bond’s real value to your portfolio.
• Tax status: The interest you earn on U.S. Treasury bills, notes, and bonds is exempt from local and state tax. Interest paid on municipal bonds is usually exempt from local (if you live in the municipality issuing the bond), state (if the municipality issuing the bond is in your state of residence), and federal tax, although you pay capital gains tax on any increase in the price of the bond. On corporate bonds, you pay both state and federal taxes, where applicable, for interest paid and capital gains taxes on any increase in price.

If you sell a corporate, treasury, or municipal bond for more than you paid for it, you’ll pay capital gains tax on the difference.